December 19, 2014

Positive Architecture

I was a babe in the woods as many first time entrepreneurs are…. We don’t know what we don’t know yet. And if we knew how hard it would be (like being a parent), we probably wouldn’t go there….. I find that the average person who has never run their own firm thinks there’s a 1 to 3 differential between being an entrepreneur and being an employee in someone else’s firm (no matter how large, mature or well-funded) in the stress level, requirement for focus, dedication of time etc. Balderdash… It’s at least 1 to 10 and probably closer to 1 to 25. Not my view alone, but the view of those who have done both.

There is something special about the first time you become an entrepreneur:

The first time you risk your own capital

The first time you back yourself

The first time you say to the world: “Here I come!”

And there is something disproportionately hard about the first time too. It’s called: Rookie Mistakes.

I know I made a few….. I shook them out of my system a long time ago, but they make me a better backer of entrepreneurs.

Rarely are they the errors or problems of Product/ Market fit, or Lack of Sales, or Failure to Raise Capital. Although all of those contribute to the big big big Rookie Mistake which is: Bad Corporate Architecture.

What’s that? It’s failing to build a strong foundation for your firm so that you can build the Eiffel Tower or Taj Mahal or Empire State Building or Gherken on top. If you don’t get this right, you’ll get worse than The Leaning Tower of Pisa.

I’ve seen some sad stories… And my great good friend Gil Mandelzis, founder of Traiana, sold to ICAP, for nearly $250 million, now on their Executive Committee, said at the EntrepreneurCountry Forum a year or so ago, ‘The line between success and failure is a very thin line.’ Very honest of Gil (which is why I have so much time for him) .. Could he have sold 4 months later? Possibly – who knows? He’s pretty impressive. It takes a giant of a founder to recognise the role of good timing in their entrepreneurial journey, and Gil is both literally one as well as one in terms of his impact, intelligence and integrity.

The grit and the dirt:

I’ve seen start-ups where the founder has made 7 of his ‘friends’ co-founders and given them founders’ equity only to be the only one doing the work, and essentially realising too late that he had >85% of the equity of the firm in a ghetto of Dead Equity. Try getting that back from people….

I’ve seen start-ups where the NXD’s are freaking out while the founder and CEO is a surge of raw human brilliance taking the market by storm.

I’ve seen start-ups where the Chairman has a veto on acquisition offers, and turns down $300 million cash offers in order to take debt from a firm run by his son-in-law – a rogue move that the founders were unable to stop, but knew was setting them up to be Thelma and Louise going over the cliff.

I could tell you stories, but would have t0 change the names to protect the guilty or my ability to work in my industry for the next 15 years. I’ve often thought of retiring to Santorini in my golden years, and just writing stories of what happened with the start-ups I backed over the years, but not sure I’ll ever retire, and not sure anyone other than entrepreneurs would believe the tales. You see every type of inspiring human ingenuity and generosity, and also the bad and ugly side of human nature too in start-ups. They are a microcosm of humanity: messy.

But instead of framing this negatively, what is a Positive Architecture?

To answer this, you have to understand power, and where it lies inside of a company.

There are 4 buckets of power in a firm:

The founder

Management as represented by the CEO

The shareholders and investors

The Board of Directors

Nothing trumps founder passion. The riskiest moves I’ve seen by other venture capitalists are frequently when they believe that the ‘founder has to go’. Entrepreneurs can definitely be their own worse enemy, but they breathe life into their firms …. Every single day. They are the DNA, the oxygen, the clockspeed, and they give the company its True North and raison d’etre. I have seen situations where the ‘hired hand’ comes in and does an outstanding job at building the business in a way that the founder couldn’t have done on his/her own. Great companies tend to have Founder / CEO’s, and most of the big tech plays do as well.

Richard Duvall, founder of Zopa, had a level of insight into the world of the Individual Capitalists and how they would think about money that remains virtually unrivalled. He was lucky that Giles Andrews was lurking about, as he is building a great firm as the CEO of Zopa, despite not being one of the founders.

Founders have power because you can’t hire them. They may have charisma or not, but they have a secret. Good ones bring momentum to the firm because of everything that led them to set the firm up. They work 100 hours a week not because they’re on overtime pay. It’s their identity. They are obsessed.

Smart VC’s want to find the best role for the founder and don’t mess with their equity. Super smart VC’s recognise that all great CEO’s were a first time CEO once. Cogitate on that for a while.

Some of the tech accelerators encourage or demand founders who enter them to vest their equity. This is a concept of taking your equity which you have by virtue of setting up the firm, and putting it in play. Always say no. Don’t believe anyone who tells you this is normal. I promise you: you will regret this massively. The appropriate response when this is brought up is: ‘Do I look like I was born yesterday?’

Founders don’t need to be worshipped, but they should always be respected despite their bad habits, ego and imperfectness. They gave life to a business which is creating jobs and wealth. All of society benefits from the work that they do, and the abnormal life they are living. If you find yourself in a negotiation with a VC who disparages the founder when he/she is not in the room, mark my words: this too will come your way. A lack of respect for where creating wealth starts is always a bad sign: a sign of greed, stupidity, arrogance or all three.

I have to admit I always get upset when I learn of a story like that of Nadia Shalaby’s: incredible drive and brilliance leads to major funding, and then a loss of her equity in the firm that the big boys found enticing. It’s not that she was the right CEO; I don’t know whether she was, wasn’t or could have been. It’s that she deserved to be part of the upside. I introduced her to Dialog Semiconductor, one of her investors, as I do so frequently to entrepreneurs who ask for help, and was pleased to learn that it had led to Arctic Sand securing $10 m, only to be devastated to hear from her that: ‘It’s ok Julie, I’ll do it again. It’s ok if I didn’t get to keep my equity in this firm’. I have to admit that I ‘went apeshit’ (a unique phenomenon that American women specialise in) when I heard this last line.

These sad stories are why second time entrepreneurs frequently try to avoid the VC industry entirely and fund their businesses through private or angel capital.

In the work that we do at Ariadne Capital, we help founders and CEO’s (and their management teams) anticipate how later stage venture capital firms will try to put in place a corporate architecture to suit them. We know that a lot of the return will come from this, so we always encourage and help founders and CEO’s to put in place a Positive Architecture ahead of their negotiation of a big Series round. It is worth it to set up a ‘gentle’ preference share class as you’ll get one that hits like a ton of bricks in your next round if not. Proactively offer Investor Rights that make sense, but don’t essentially make you an employee of the investors. Make sure that your Board of Directors is non-executive and supportive.

The CEO or management also have a tremendous amount of power in determining a Positive Architecture, but they may be smaller options holders instead of shareholders. Investors will want to know that the CEO is incentivised properly if he /she doesn’t have founders’ equity. Over time, power does shift from the founder to the CEO in many situations which is why it’s incredibly important that they respect each other and can work well together. Sculley / Jobs stand-offs tend to always destroy value for shareholders either short or medium term.

There are investors and then, there are investors. Investors don’t always win. I know Net-a-Porter angel investors who didn’t make any money (or at least they told me so), and I know venture capital firms that have acted with enormous empathy, energy and hutzpah to back entrepreneurs as true business partners. Gil Mandelzis credits Don Valentine, his venture investor, with significant support for Traiana. Not all are good or bad, make money or not. But what is clear is that there is most of the time an almighty battle for control of the firm which is either there in a company like a benign current, or a volcano and fight to the death. Keep your eyes wide open to the fact that the power struggle *is* there; it’s merely a question of how benign/active, and how aware of it you are.

I remember sharing with a bright entrepreneur who wanted Ariadne Capital to fund his business that in reading his Shareholder Agreement and Articles of Association (it’s the legal geek in me that enjoys doing things like this), I noted that if he missed an interest payment in the following year, he would be diluted by 99%. His reaction was: ‘they’re good people, Julie. Chill’. Good people don’t have clauses like that in investor documents.

I also came off the phone once with the CEO of one of our portfolio companies and some of their angel investors who worked at Goldman Sachs not too long ago, and got a call back from one of the Goldman guys immediately. We were negotiating a termsheet, and I kept stressing ‘alignment’ which is the secret to most things in life to all parties on the call. Angel investor from Goldman’s opening line to me on the phone 1:1 was, ‘You kept banging on about alignment there Julie. In my experience, it’s grossly overvalued’. You draw the conclusion.

A Special Word about Boards of Directors. Choose them wisely. Trial them on an Advisory Board first if you can. Check their reputation in the market. I find that many entrepreneurs offer Board seats far too quickly without really testing whether there is alignment, and how they see company development. More importantly though, NXDs should be adding value, and you as a founder should be asking them what they will bring to the table, not setting up a layer of structure to boss you around. If you have a problem with asking a future NXD what they plan on doing, then you need to reflect. Note their favourite thing to say is: providing corporate governance but that’s rarely an issue early on in a start-up.

There is a world of difference between Leadership Teams and Executive Committees who are consulted and run firms, and Boards which represent shareholder interests and give feedback and input based on their experience. I’ve found that the right Board can help a company grow more quickly, and I’ve also seen situations where the CEO was having a strategy argument every Board meeting. The Board should have the business plan for the year presented to it, and then either back the CEO or find a new one.

Entrepreneurs who are going through a funding round have to become very knowledgable about where the power lies in the investment round which is being proposed. You can’t rely on your lawyers, your CFO, your advisors to tell you what the agreements say. Fund raising is like dating. Make it uncomfortable to make sure you know your other half. Don’t just wear your red dress, flatter the other party, provide information on a need to know basis, and then, wham! get the money or the girl/boy, and find out that – and here’s the central point of all start-ups and Positive Architecture: The Deal is Always Done at the Beginning. Dear reader: the most you ever do in life after the deal is done is to course correct. You never fundamentally renegotiate the terms. So careful when you close and what you close.

My final word is that if you read this and say, Julie’s article confirms once and for all that I’m a control freak. Welcome to EntrepreneurCountry. Most of us are, and it’s not a bad thing.